Tariffs On, Tariffs Off, Tariffs Back On (Sort of)

“The new Administration is in the process of implementing significant policy changes in four distinct areas: trade, immigration, fiscal policy, and regulation. It is the net effect of these policy changes that will matter for the economy and for the path of monetary policy,” Fed Chief Jay Powell said in prepared remarks Friday afternoon.

There is plenty to unpack in Powell’s comment, but we want to concentrate on what is sparking the volatility in the market, and Powell touched on a couple of points.

President Trump’s one-month delay of levying a 25% tariff on goods imported from Mexico and Canada expired last week. Trump briefly restored the tariffs, then postponed them for an additional month for items included in the USMCA between the U.S., Mexico, and Canada.

The USMCA replaced NAFTA, a trade agreement in effect between 1994 and 2020.

Investors are fretting over tariffs amid worries that they will raise prices at a time when inflation remains elevated. And there are concerns that nations subject to tariffs will raise barriers of their own, which could hinder U.S. economic growth and exports.

Additionally, economic uncertainty arising from policy changes may discourage some businesses from expanding or retooling until the situation stabilizes.  In other words, investors view the tariffs as economically disruptive, leading to market volatility.

According to U.S. Census data, the two biggest U.S. trade partners are Mexico and Canada.

Clouds on the horizon

“Could we be seeing that this economy… (is) starting to roll a bit? Sure. And look, there’s going to be a natural adjustment as we move away from public spending to private spending,” Treasury Secretary Scott Bessent said Friday on CNBC.

“The market and the economy have just become hooked. We’ve become addicted to this government spending, and there’s going to be a detox period,” he added.

Investors perceive events through a narrow lens: Will they gain or lose? Will it help or hurt stocks? That is how we frame the conversation.

Budget cuts, federal layoffs, and layoffs of private government contractors, coupled with economic uncertainty regarding tariffs, could put the brakes on the economy over the shorter term, as Bessent conceded.

That is what the market is responding to (a discussion of government spending/waste falls outside the scope of this analysis).

More common than you think

We recognize that pullbacks occur from time to time. The S&P 500 Index averages a pullback of at least 10% about 1.1 times per year. We haven’t undergone a 10% peak-to-trough decline since late 2023.

Since the S&P 500’s peak on February 19, the index is down 6.6% through the most recent bottom on March 6 (MarketWatch data). So far, the magnitude of the pullback is far from unusual.

In the past, pullbacks and corrections have been driven by recession fears, higher inflation, trade issues in 2018, the fiscal cliff in 2012, overseas challenges such as the European debt crisis, and more.

In other words, corrections don’t happen on their own. They need a catalyst. While stocks are modestly off their highs, the consensus that the economy won’t slip into a recession has helped cushion the downside.

As with prior pullbacks, we can’t pinpoint the bottom. The lucky few that may call it will find that consistently predicting market tops and bottoms will be out of reach. Simply put, no one knows the future.

What we do know is that broad market indexes have a longer-term upward trend, and market declines eventually run their course. Historically, the patient investor has been rewarded.

Economic Muscle with a Dash of Uncertainty

On February 19 and February 20, the S&P 500 Index eclipsed its prior all-time high set in late January, according to data provided by the St. Louis Federal Reserve.

What helped lift the index to a new high?

1. The economy has been expanding, which supports corporate profits.
2. Corporate profit growth is strong as Q4 S&P 500 profits are on track to rise an impressive 17%, per LSEG, as of Feb. 28—with all but 4% of S&P 500 firms having reported in Q4.
3. While discussions of rate cuts this year have waned, Fed Chief Jerome Powell has avoided mentioning any possibility of additional rate increases, despite stubbornly high inflation.

Despite the upbeat mood, uncertainty crept into trading late in the month, and part of the problem has been the persistent threat of tariffs.

The new year is young, and the threat of tariffs isn’t new. But investors seemed to be taking them in stride. Observe the consecutive new highs for the S&P 500 during the third week of February.

In essence, investors don’t (or didn’t) appear to believe the president will follow through on his threat to levy tariffs. Instead, they view it as a strategy to gain concessions.

In other words, investors have adopted a glass-half-full attitude.

But as February ended, the ‘will he or won’t he’ significantly raise tariffs shifted to ‘he might.’ The president said on his social media platform that tariffs on Mexico and Canada will be enacted this week. However, it is not clear whether this is merely a threat to extract additional concessions.

First, let’s discuss the potential economic impact of tariffs and why it is creating economic uncertainty among investors and some volatility.

Investors and financial markets view trade barriers as an impediment to economic growth.

1. Tariffs may boost inflation, at least over the shorter term.
2. Tariffs may slow economic growth as trading partners retaliate and erect walls to U.S. exports.
3. While higher barriers to U.S. markets might benefit some domestic industries, overall, however, tariffs lead to increased economic uncertainty (Figure 1), which can undermine business confidence and business spending.

Despite the worrisome rise, the index isn’t designed to foreshadow a recession, but it illustrates that economic anxieties are injecting a degree of uncertainty into the economic narrative.

Additionally, measures of consumer confidence, including a closely followed gauge from the Conference Board, fell in February amid heightened economic uncertainty and worries about inflation.

That said, let’s be careful not to overthink soft measures of economic data like consumer confidence surveys.

While some economic reports hint at a slowdown, it is too soon to declare that last year’s robust pace of economic growth has been replaced by an economic soft patch. Why? One month is simply a data point, it’s not a trend.

Perhaps weak consumer spending early in the year was weather-related. Besides, it’s not unusual for the data to vary from month to month.

Investor’s corner

Investors bracing for tariffs and the possibility of softer growth have shifted into more defensive sectors (Wall Street Journal). Note that the Dow Jones Industrial Average, which has lagged during the bull market, is off to a respectable start this year, while riskier high-flying sectors, such as technology, are struggling (the Nasdaq).

We are mindful that market volatility may lead to uncertainty, but we encourage a long-term perspective that avoids decisions based on recent market action.

Be leery about trying to time the market. Market timers occasionally get lucky, but consistently timing peaks and valleys is nearly impossible.

Your financial plan enables you to make more thoughtful investing decisions, removing the emotional component that may cloud decision-making when stocks are surging or volatility sets surfaces.

Earnings Impress

On January 13^th, the Wall Street Journal published an article entitled “Investors Hope Earnings Season Can Revive Faltering Stock Rally—With the Fed unlikely to cut interest rates as quickly as hoped, corporate earnings growth becomes even more critical.”

It’s not unusual to see a financial website write a story expressing concerns about the upcoming earnings season—in this case, Q4 2024.

As the season unfolds, we typically see firms top conservative profit estimates, and Q4 was no exception, per LSEG. As the new year began, LSEG expected S&P 500 companies to report a 9.6% rise in profits compared to one year ago (estimate published by LSEG as of January 1).

With 85% of companies having reported Q4 results, LSEG’s survey pegs Q4 profit growth at 15.7%, the best showing in three years. That’s well ahead of the early forecast.

In part, strength in profits among some of the large tech firms is helping drive earnings growth. In part, the economy is expanding, and the public is spending money, which also supports corporate profits.

Stronger profits contributed to rising stocks during the current earnings season, and the S&P 500 Index achieved record closes last Tuesday and Wednesday, according to MarketWatch. These records occurred before a selloff at the end of the week.

Other factors also influence the direction of equities, such as interest rates and the economic outlook. Furthermore, developments related to tariffs may affect the economic outlook. Anxieties about tariffs have been an on-again, off-again headwind over the last month.

While the movement in stocks doesn’t have an immediate one-to-one correlation to corporate earnings, over a longer period, earnings have a significant impact on stocks.